First Steps When Considering Digital Assets: Understanding the Regulatory Framework

By Ed Wegener

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It is a familiar issue. Innovation moves at lightning speed while regulators try to apply existing rules to products and technology never contemplated when the rules were enacted. By the time regulators succeed, the goalposts have moved. It is a frustrating but necessary dance. The industry wants to innovate, and regulators want to protect. This is currently what is playing out with digital assets – an area identified by both the SEC and FINRA as priorities. If your firm is considering whether to offer clients the option of investing in digital assets, we would like to give you the following references to help build your roadmap.

DAO Report

The first major guidance came when the SEC issued a 21(a) Report in 2017 where it found that digital DAO tokens were investment contracts. As a result, offers and sales of the tokens would need to be registered or exempt from registration. In the report, the SEC outlined their analysis using the Howey Test in concluding that the tokens were securities. They also concluded that platforms that facilitated secondary trading of DAO tokens would be required to register as exchanges or as an ATS. Since then, the SEC has been cracking down on unregistered token offerings while working to develop a regulatory framework for digital securities.

Framework for “Investment Contract” Analysis of Digital Assets

The SEC issued further guidance on the application of the Howey Test to digital assets while simultaneously issuing a No-Action Letter concluding that tokens issued by Turnkey Jet, Inc. were not securities. In doing so outlined key factors that would be considered in making such a determination.

SEC/FINRA Joint on Custody of Digital Assets

The SEC and FINRA provided guidance regarding a number of non-custodial activities that do not present the same level of concern for the regulators provided that relevant securities laws, SRO rules and other legal requirements were met. At the same time, they outlined concerns and challenges regarding the application of rules related to custody of digital assets including the Customer Protection Rule, books and records requirements, and SIPC considerations.

SEC No-Action Letter to FINRA re. ATS Role in the Settlement of Digital Asset Security Trades

In September 2020, the SEC issued a No Action Letter to FINRA which applied the Joint Statement to broker/dealers operating alternative trading systems (ATSs) trading digital assets. The letter communicated that the SEC would not seek enforcement action under Section 15(c)(3) and SEC Rule 15c3-3 against firms that operate an ATS which trade digital securities in the secondary market under certain circumstances.

We are far from done as the regulation of digital assets as securities continues to evolve. The SEC’s Finhub and FINRA’s Office of Financial Innovation are working with the industry help foster innovation while at the same time trying to ensure that critical safeguards are in place. Keep an eye out for future blogs and podcasts where we will get into more detail about this evolving guidance, discuss some key roles of broker-dealers in the digital ecosystem and discuss some key challenges firms and regulators face.

About The Author
Photo of Ed Wegener

Ed Wegener

Ed Wegener is an innovative compliance, risk management and supervisory controls expert with deep understanding of Federal Securities Laws and the rules of self-regulatory organizations, as well as technology optimization and risk mitigation. Prior to joining Oyster, Ed held several posts in FINRA, most recently as  Senior VP and Midwest Regional Director.